SHORT-CIRCUITING
The conflict between long-term business strategies and fund managers’ desperation for a quick fix leaves markets in flux and executives under pressure. It’s high time for a culture change
With that appealing knack of his for knowing what will irritate the City, Ed Miliband is threatening to double capital gains taxes on the sale of shares owned for less than a year — if he ever gets into power. Considering the average holding period for FTSE shares is seven months, according to a 2010 paper by the Bank of England’s Andy Haldane, the policy would revolutionise the way that HNWs invest and the manner in which the UK economy functions.
The commotion surrounding investors’ short-term focus is being fuelled by the public’s increasing reliance on the markets. Retirement provision is being covertly privatised — as life expectancy rises at the same time as Westminster’s ability to finance pensions decreases — so fund returns are more important than ever to fill the gap. Unfortunately, predictions from Goldman that the FTSE 100 will breach 7,000 in 2013 conceal a wider concern that the fund managers entrusted to build savings are not allocating resources in a way that maximises long-term value.
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The cause is clear. According to George Latham, an expert on sustainable investment at WHEB Asset Management (at which Ben Goldsmith is a partner), short-termism originates in the way that fund managers are held to account. ‘Quite reasonably, their clients expect regular performance updates and a comparison with what could be achieved elsewhere, yet the side effect is that money managers obsess about quarterly results and how they weigh up against benchmarks.’
As such, fund returns are diminished by closet indexing, the process by which fund managers align themselves so closely to benchmarks that their clients won’t fire them for underperforming, a practice so prevalent that the FT felt confident enough to ‘out’ 24 of the 280 funds in the UK All Companies sector in 2012 for doing this.
Of course, corporate executives have cottoned on to what is happening in investment circles. In order to maximise profits over that seven-month timeframe, 80 per cent would be willing to slash spending on advertising, hiring and research and development, a survey by American academics John Graham, Campbell Harvey and Shiva Rajgopal estimates. R&D is key for the long term — studies suggest that doubling it produces a 70 per cent leap in output — but companies can now even seem frightened of it.
‘In 2011, Leo Apotheker became CEO of HP,’ says Daniel Pinto, managing partner of Stanhope Capital and author of Capital Wars. ‘Then, over one-third of the company’s revenues was derived from PCs, a business with shrinking margins — less than 4 per cent — and so Apotheker suggested that HP invest in software development and services instead. The board said yes unanimously. But 2011 was a difficult year for the markets and the tech sector was hit particularly hard, with HP’s share price falling approximately 40 per cent. Although Apotheker’s policy was the right thing to do, the board panicked and so did HP’s investors. Fear overtook reason, and Apotheker was asked to resign. That is the story of short-termism: you know what you have to do to create growth, but your hands are tied by the markets which do not have the patience to let you do it.’
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The starting point for solutions is John Kay’s review of equity markets and long-term decision making. Commissioned by Vince Cable, it says that long-termism requires meaningful investor participation: ‘The quality — and not the amount — of engagement by shareholders determines whether the influence of equity markets on corporate decisions is beneficial or damaging to the long-term interests of companies.’ On top of ending quarterly reporting, Kay offers two proposals. First, healthier engagement between corporate and investment managers, with the establishment of a forum and the inclusion of strategic issues in the Stewardship Code for corporate governance. Second, the re-alignment of incentives, with corporate directors remunerated on the basis of long-term business performance and investment managers holding stakes in their vehicles for similarly lengthy periods.
But does the London School of Economics professor and FT columnist go far enough? Not according to the Labour Party’s mirror report, which called for tapering capital gains taxes on share sales (starting at 50 per cent in year one); nor the European Commission, which is consulting on how it can foster long-term financing; nor the G30 think tank, which has called for best-practice guidelines to be published on long-term investment. Yet the multiverse of alternate models might, conversely, suggest that the Kay Review has been a success; after all, reports are only as good as the debates they spark.
‘Kay’s concept of stewardship is a simple and elegant solution for changing the culture of investment,’ says Cath Tillotson, managing partner of wealth management consultant Scorpio Partnership. ‘The challenge will come in the execution. “Culture change” relies on all participants in the market having the judgment, knowledge, wisdom and will to make the same shift; plus, the concepts of stewardship, trust, confidence and good practice are incredibly difficult to define and are open to wide interpretation.
‘Indeed, as Kay himself argues, we have got into this mess because of interpretation,’ she continues. ‘The Companies Act already states that a director’s duty is to act in a manner which promotes the success of a company considering the long-term consequences of their decisions. However, if success is judged in terms of profit, then it is equally a director’s duty to maximise that profit for the benefit of the shareholders.’
What is needed therefore, is more thorough and frequent analysis of the success of corporate directors at managing their PLCs in the long-term interests of employees, partners, communities and the environment. George Latham suggests that investors should expand stock analysis by integrating the insights offered by measures of employee and customer loyalty, emissions intensities that point to operational efficiencies and vulnerabilities to regulation and measures of brand reputation.
Connecting the dots
It then becomes a question of how to connect investors with the investment opportunities that reflect their views on long-term decision making, employee welfare, business conduct and the environment, says Cath Tillotson. That is the responsibility of the financial intermediary community which has successfully created similar frameworks in the past, such as risk-profiling instruments and socially responsible investment tools.
The imperative to act is clear. Short-termism is undermining corporate and investment management so badly that a pensions shortfall is inevitable. The public will be denied their ‘entitlements’ and, as night follows day, an argument will break out over who should foot the shortfall.
‘The chain of short-termism that runs through corporate and investment management is toxic,’ says Daniel Pinto. ‘And it is dragging us down as a civilisation.’
Illustration by Phil Wong
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